Four big banks need more capital to weather recession, US finds

A sign for a Bank of America branch in downtown Philadelphia, Thursday. Some of the nation's largest banks will be scrambling to demonstrate that they can raise capital after results of government stress tests leaked out, showing many need more funds. The Treasury Department will officially release results later Thursday.

Matt Rourke/AP

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The US government is asking America’s largest banks to raise more than $65 billion in fresh capital, in a move designed to build a foundation for economic recovery.

That’s the upshot of a two-month “stress test” process assessing the health of 19 leading financial firms, according to preliminary news reports. Full results will be officially announced Thursday at 5 p.m.

For the first time since financial turmoil erupted more than a year ago, regulators are publicly drawing lines of division between between banks that are positioned to weather the recession and those that may require more resources. Having enough capital, as a base for future loans and for covering potential losses, is the essential measure of banks’ health.

Some smaller banks will also need more capital. One of the largest, JPMorgan Chase, is among a handful of big banks that regulators say are well-capitalized.

About half of bank loans made in the United States flow from the 19 firms that underwent the stress tests, so the government’s goal is to make sure those prominent banks remain able to provide credit for consumers and businesses at a fragile time.

“The exercise has been comprehensive, rigorous, forward-looking,” Federal Reserve Chairman Ben Bernanke said in a speech Thursday morning. The Fed and other regulators conducting the tests want the largest banks to “remain well-capitalized and actively lending, even should macroeconomic conditions prove worse than currently anticipated,” he said.

Credit markets vital to recovery

Returning banks to health will be an important indicator of whether the US economy recovers in a buoyant way or remains mired in a slump, economists say. Their widely shared view is that other policies, such as low interest rates or the Obama administration’s large stimulus program for the economy, won’t revive economic growth if credit markets aren’t functioning normally.

Each bank that needs to raise more capital can do so in a variety of ways, within a six-month deadline. It can do a public-stock offering, sell some portions of its business to raise money, or take an infusion of public funds from the Treasury’s Troubled Asset Relief Program (TARP). Part of the solution, and perhaps the bulk of it, may be for a bank to convert so-called preferred stock shares – a low-level form of existing capital that blurs the line between debt and equity – into common stock. Common equity is considered by regulators and investors to be the strongest form of capital. Some preferred-share conversion may involve funds that came from the TARP.

Many of these moves, by increasing the total amount of common stock, will dilute the value of the common shares that investors currently own in the banks.

Bank stocks on the rise

Despite that, bank stocks generally have risen in the past week amid speculation and leaks about the stress-test results. In trading Thursday morning, banks including Citigroup, JPMorgan, and Wells Fargo erased much of the share-price gain they posted a day earlier.

The longer-term trend is that bank stocks have risen far above the lows they hit in early March. That may reflect two factors, industry analysts say: relief that the capital-raising demands aren’t larger, and general indications that banks and the economy are doing better than was feared two months ago.

The biggest banks generally surprised analysts with strong earnings in the first quarter of the year, for example, and some economic reports this week suggest that the pace of job losses is cooling.

The first-quarter profits at many banks are not necessarily an all-clear signal. The good news is that banks have been reaping fees from new activity, such as refinancing mortgages, and also making the most of low Federal Reserve interest rates to expand “spreads” – the difference between the rates they charge and the rates at which they borrow. The Federal Deposit Insurance Corp. has also been guaranteeing bank debts, a move that lowers banks' cost of long-term borrowing.

Still, a large number of loans are going into default, and the amount yet to come could be larger than the stress tests anticipated, many analysts say.

Were stress tests stressful enough?

One common critique of the tests is that the economy’s actual performance may prove to be worse than the scenarios envisioned by regulators who did the assessment.

Bank analysts at FBR Capital Markets calculated that in an “extreme” case, capital needs might jump to $200 billion at just 12 of the big banks, which they focused on.

Even without looking at a worse-than-expected scenario, economists at the International Monetary Fund recently concluded that the US banking industry needs about $275 billion in new capital.